The Tax on Dividends from Mutual Funds
Mutual funds are pass-through investment vehicles: If the funds pass at least 90 percent of the portfolio’s profits to the shareholders, the fund’s tax obligation gets passed through to the shareholders as well. If the fund holds any income, it must pay taxes on that, so most funds pass through 100 percent of their profits. The profits that mutual funds distribute can take many forms, each with its own tax rules:
Capital gains: From the sale of assets
Ordinary dividends: Mostly from stocks, but can include all kinds of taxable income
Interest distributions exempt from taxation: Such as municipal bonds or other obligations from state and local governments
Interest: From bonds and other debt obligations
Non-dividend distributions: A portion of your initial investment returned to you, which isn’t considered income
To further complicate the determination of tax rates on profits is the fact that holding requirements for lower tax rates apply to both how long the fund holds certain stocks and how long you hold your shares in the fund. At the end of the tax year, your mutual fund issues you a 1099-DIV indicating which dividends and capital gains qualify for the lower tax rates and which don’t inside the fund. To determine whether these dividends and capital gains actually qualify for you, you must account for the length of time you held your shares in the fund.
Don’t assume because the fund says this amount of dividends are qualified that they actually receive the lower tax rate. The fund doesn’t take into consideration your holding period when it declares qualified dividends. It just lets you know that the fund has done its part to make them “potentially” qualified by holding them for the 61-day period. Both you and the fund need to hold the appropriate shares for 61 days of the 121-day period surrounding the ex-dividend date. But they don’t have to be the exact same 61 days.